Chart: Chinese Rate Hike Doesn’t Matter

For the second time this year and the fourth time since 2010, the Chinese government raised interest rates by 25bp, bringing its lending and deposit rates to 6.31 and 3.25 percent. Like many other countries around the world, China is worried about rising inflation pressures and the negative impact that it could have on inflation expectations and the overall economy. Over the past year, China has tried to combine rate hikes with higher reserve requirements for banks and the results have been limited. The recovery in the global economy has boosted growth expectations for China, forcing the central bank to take continued actions to slow their economy. While the timing of the announcement was a surprise, everyone expected more tightening from China because of the strength in commodity prices. In addition, China rarely make one-off moves which explains why the market’s reaction to China’s rate hike was so muted. High yielding currencies initially sold off after China’s announcement but since then, they have recuperated nearly all of their losses.

Diminishing Impact of Chinese Rate hikes

Each Chinese rate hike has had a smaller and smaller impact on the currency market. The first rate hike back in October elicited the biggest reaction because it was the first rate hike in nearly 3 years. At the time, all of the pro-cyclical currencies plunged against the U.S. dollar with the euro falling 1.5 percent and the Australian dollar declining by more than 2 percent. When China raised rates again on Dec 27th, the euro ended the day slightly higher against the U.S. dollar while the Australian dollar remained unchanged. In February, the reaction was slightly larger in the EUR/USD, GBP/USD and USD/JPY but the AUD/USD and NZD/USD ended the day higher. The price action today is even more muted as indicated in the chart below which suggests that investors are skeptical about China’s ability to tame their roaring economy. Slower Chinese growth is undoubtedly negative for global growth but we have been down this road before and even though there have been signs of slower growth in the Chinese economy, it has not had a significant impact on demand.

Rising inflationary pressures is the primary motivation behind China’s rate hike. With commodity prices continuing to rise, China did not want to take any risks, opting to preempt a further increase in inflationary pressures by raising interest rates. Given the health of the Chinese economy and the prospect of stronger global growth, we have not seen the last of China’s policy actions. We expect more interest rates hikes and more reserve requirement ratio hikes in 2011.

*April reaction is based on currency value change from Chinese rate hike announcement to 9am NY Time / 13:00 GMT

China vs. Japan vs. U.S. and Yuan

News that China surpassed Japan as the world’s second largest economy is one of the biggest stories in the financial markets. For more than 4 decades, the only country with a larger economic output than Japan was the U.S. However over the past 20 years, the Japanese economy stagnated, giving China the opportunity to usurp Japan and snag a title that it has held since 1968. Just 5 years ago, China’s gross domestic product was around $2.3 trillion, about half Japan’s but rapid growth has pushed economic output to $5.88 trillion in 2010. While the Chinese economy grew, the Japanese economy contracted by 1.1 percent, bringing Japan’s economy to $5.47 trillion last year.

Although the absolute size of their economies are comparable in U.S. dollar terms, Japan and China could not be any more different. China has 10 times more people than Japan but the GDP per capita is also 10 times less. Some may look at this as room for growth but the rest of us may feel that the income inequality reflects the inherent weakness of the China economy. More than 150 million people, which is 10 percent of the population live on less than $1.25 a day. While growth in Japan is likely to pick up in 2011, it will have a very difficult time reclaiming its title from China.

Will China Usurp the U.S.?

The next big question investors are asking is whether China will usurp the U.S. to become the world’s largest economy. Currently the U.S. economy is 3 times the size of China’s which means that the Chinese economy would need to triple in order to match U.S. levels. This is an incredible feat that will be difficult to achieve but not inconceivable. In fact, many economists believe that China could eclipse the U.S. sometime between 2020 and 2030. Chinese incomes are rising and it is the government’s goal to reduce income inequality significantly over the next decade.

Implications on the Chinese Yuan

For the financial markets, this means that over the next 20 years, there will be a significant change in the dynamics of the foreign exchange market. Not only will the Chinese Yuan be revalued and set at higher and higher levels, but I expect much more flexibility in the Chinese currency. In fact, by 2030, I would be surprised if the Chinese Yuan did not become a free floating, fully convertible currency that is as actively used as the euro and possibly even the U.S. dollar. This will of course undermine the importance of the Japanese Yen and other currencies.